Question

5. (io points) Describe the effects of the following phenomena in both the short run and the long run: (a) (s points) A temporary negative supply shock. 0b) (s points) A permanent negative supply shock.

Answer 1

In each of the following graphs, long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect, with long-run equilibrium price level P0 and real GDP (which is equal to Potential GDP) Y0.

(a) A temporarily negative supply shock will reduce aggregate supply, shifting SRAS0 leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1, creating stagflation in short run. In long run, since the shock was temporary, aggregate supply will rise and SRAS1 will shift rightward to SRAS0, restoring long run equilibrium at point A.

(b) A permanently negative supply shock will reduce aggregate supply, shifting SRAS0 leftward to SRAS1, intersecting AD0 at point B with higher price level P1 and lower real GDP Y1, creating stagflation in short run. In long run, expectations will adjust, which will increase aggregate demand, shifting AD0 rightward to AD1, intersecting SRAS1 at point C with further higher price level P2 and restoring real GDP to potential GDP of Y0, eliminating the stagflation.